If you're looking for a stable investment that earns a tax-free return, consider investing in tax-exempt bonds.

Tax-exempt bonds are financial instruments that help local governments borrow money. For instance, if Austin, Texas, needs cash to build new environmentally friendly water plants, it can borrow from individual investors by selling bonds. The investors lend their money to the city, and in exchange, the city agrees to pay the loan back with interest. It's a win-win situation. Austin gets new utilities, and investors get a low-risk return on their investment.

Local governments, like the one in Austin, get a helping hand from the federal government. Because Congress wants to encourage private investment in local government projects, the interest payments that investors receive from most local government borrowing is not taxed. Although it must be reported on your Form 1040, tax-exempt bond interest is not included in your taxable income, hence the name, "tax-exempt bonds."

There is an additional perk. Most tax-exempt bond interest escapes not only the ordinary income tax but the alternative minimum tax, as well.

Of course, not all bonds are tax-exempt. Interest on federal bonds, like the popular Series EE and Series I savings bonds, is fully taxable. In addition, corporate bonds, like those issued by


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don't directly benefit the general public, so investors who buy them receive no special treatment.

Likewise, if a local government issues bonds and uses the money for a non-public purpose, interest that investors receive from the bonds will be taxable. How can you tell the difference? Your investment adviser or online service will tell you which bonds are tax-exempt, which ones are not, and which ones must be counted for the alternative minimum tax.

When deciding whether to invest in state or local bonds, you should consider a number of things. First, do you really need a tax exemption? If you are investing inside of a tax-free account, like an IRA or a health savings account, buying tax-exempt bonds doesn't make sense. Because of the savings that they offer, tax-exempt bonds usually pay less interest than taxable ones.

To determine whether a particular bond is right for you, you should figure out whether your tax savings are bigger than the extra interest you could earn if you bought a taxable bond. For instance, if a tax-exempt bond pays $5 of interest and saves you $3 of tax, it is worth $8 to you ($5 cash plus $3 savings). But a taxable bond that pays $15 is a better overall investment. After paying $3 of tax, you will still have $12 in your pocket, which is better than the $8 value provided by the tax-exempt bond.

Conversely, if the taxable bond pays only $10, it is not a good choice, even though it pays twice as much interest as the tax-exempt bond. After paying $3 of tax, you would have only $7 left, which is less than the $8 value of the tax-exempt bond. (Of course, math in the real world will be more complicated because your tax rate may increase as your income increases.)

Risk should also play a role in your decision making. This is because not all tax-exempt bonds are created equal. Some are supported by a local government's entire revenue, while others are supported only by the revenue from a particular project. If you are risk averse, you may be more comfortable investing in a bond that is supported by all of a city's resources rather than one that is supported only by revenue from the water department, for instance.

In addition, not all local governments are created equal. If you can't afford to lose your investment, you should check a city's creditworthiness before you lend money to it. Finally, keep in mind that some bonds are insured.

Last, but not least, your decision to buy tax-exempt bonds should also account for future market conditions. If you think interest rates will increase, you may not want to lock yourself into a low interest rate investment. But if you think that future investment conditions will be unstable, or that tax rates will increase precipitously, tax-exempt bonds may provide a low risk and high savings alternative to other market investments.

In the end, the decision is yours. But if you're looking for a tax-free way to make money while you save money, you may want to consider tax-exempt bonds.

This article was written by a staff member of MainStreet.com.